It's all About EM Demand, China and India

With all the sturm und drang of the US political season, it is excusable that investors are looking less to emerging markets (EM). However for commodities traders and investors, that is not possible. The fact is that almost all the growth in commodity supply and demand comes from EM. And right now EM is in serious trouble.

This article will focus on commodity demand. Over the medium term, there's not much that can happen to supply. Putting in a new world class mine or plantation province takes many years. These were cut back sharply starting in 2013, and will not revive for quite a while. So over the shorter term commodity prices will be set by demand.

Here's a table of the World Steel Association's forecast for steel demand in 10⁶  tonnes:

	2016	2017	Change
Developed Markets	406	410	4
Emerging Markets	436	457	21

So EM is the growth driver for steel. The numbers are similar for virtually all industrial commodities. DM economies expand in the commodity-light service sectors. EM economies expand by building things.

The two biggest EM economies are China and India. Both of these are having problems, for different reasons:

China is experiencing massive financial outflows. It's impossible to get exact numbers, but Barclays thinks it was $207 billion in the third quarter. Data from the Federal Reserve TICC report shows that China and Belgium (China holds treasuries in Belgium for some reason) liquidated $184 billion in treasuries during Oct alone. So the outflow may be speeding up.

Analysts have varying reasons for the massive movement out of China. Rising US interest rates, the falling Yuan and a clampdown on corruption in China are mentioned. But my view is that this is wealthy people in China seeing the end of the Chinese growth model. China is going through the same process that Japan went through in the 80s. The export-led growth is maxed out, but China still has a huge savings rate. So the capital is seeking a better and safer home. Trump is speeding this up, since he will certainly reduce China's exports to the US. But it would happen anyway.

The Chinese leadership realizes this and is steering the economy toward services. Long term this is the right path, but the process will be bumpy. Basically, a lot of heavy industry will have to be shut down. Services are much less capital-intensive than manufacturing, so the returns on capital will be lower. Also, services are far less commodity-intensive, so that demand will be muted.

So China will not have a need for incoming capital. It has also massively expanded its higher educational system, so it probably won't have much of a need for foreign technology either. History tells us that if a nation doesn't need foreign assets for growth, it doesn't let foreign companies make much money. So my advice is to avoid Chinese stocks as an asset class. This is also negative for US companies that have major operations in China (GM, WYNN, YUM).

India is a somewhat different story. It is at an earlier stage of the growth cycle. Exports and construction have a large place to play in future growth. Because of the rule of law and English language, it also has a major stake in service exports, a particularly good sector. The problem here is self-generated. Like many EM countries, much business is done in cash. This is done to avoid taxes as well as distrust of the financial system. India wants to change this. So the government has called in all large denomination bills. But business culture doesn't change overnight. So a lot of business has ground to a halt. In time this will dissipate, and India will resume its growth.

The Hike

The Fed raised rates by a quarter point yesterday. This was as expected, but the tone of the statement and the press conference was rather hawkish. So everything sold off, including most commodities. Here's my take...

The big number to me was the forecast for growth, at about 2%. If this is true, then the Trump optimism is worth zero. That's the same crappy growth we got during Obama's eight years. It's also a big step down from previous Fed forecasts. Many people may not know that the Fed has been forecasting a return to 3+% growth for about six years. They have been wrong of course. This year they finally threw in the towel, probably at the exact wrong time. I believe 3% is likely.

Any rise in interest rates is bad for commodities, especially monetary-tied ones like gold. But if the rise is due to a stronger economy, that's actually a good thing. The big risk is what happens to emerging markets, where most of the demand growth comes from. A protectionist US would be a great negative. We have to see how Trump policy evolves. However, the people he has picked for his economic advisors are all pretty savvy, and undoubtedly understand what is at stake. So I bet they will tread lightly. In all, I'm still pretty bullish, especially on equities. The major risk here is that many commodities are not longer cheap, so you don't have that long term value working in your favor. But a lot of the companies I hold can do quite well with current prices.

I bought back the South 32 shares I sold last week.

Uranium

Uranium is close to breaking out. Here's a graph of U.TO, a Canadian fund that only holds uranium as assets:

So it filled a gap. Might have to chop around for awhile before it moves higher. I'm keeping my whole position.

Here's a graph of CCJ, the leading western uranium company:

I took some off this morning. Again, at important chart levels.

Was I wrong on platinum?

A friend took issue with yesterday's post about platinum being overvalued. Here's his argument:

There has been a major shift in light vehicle emissions catalysts over the last few years from platinum to palladium. Partly this was economic; Pa is cheaper than Pl. Also the emissions fiasco at Volkswagen and the changes in emission testing that it engendered is causing Europe to shift autos from diesel to gasoline. Diesel uses more Pl and vice versa.
But this has overshot. Pl is only about 25% more expensive than Pa now. Many of the new generation of catalysts have a Pa/Pl ratio of 7 : 1. But world supplies of Pa/Pl are only 1.2 : 1. So the arb is now the other way; it favors Pl.

I don't know what to make of this, although my friend is really smart investor. Does anyone reading this blog have any ideas? Comment below.

Position Changes Today

I got out of my platinum position. It actually looks quite good on the chart, and I wouldn't be surprised if it continues to move up. But that's not how I trade. I look for long run fundamental under or overvaluation. Here's a long run chart of platinum in constant 2016 dollars:

So platinum is still pretty expensive on this basis. Not for me.

I also added to POT and uranium (CCJ); these are cheap. The basis for the POT investment is the same as my DE one. Here's the SA article of Oct 12.
http://seekingalpha.com/article/4011644-like-john-deere

Back blogging

I haven't posted for quite awhile here. Instead I switched my posts to Seeking Alpha. That has allowed me to reach far more viewers than I can here. In fact, I have over 10,000 viewers there!
However, SA is set up for long heavily thought out posts, not quick short ones. So I'm going to put the short ones here, and reference SA when necessary.

So let's start. A few months ago I went long South 32, the Australian miner. It is my largest position, and it's been a real winner. Today I took off 16%. It has run up today on a Citi buy recommendation, and I love to fade short term moves like that. Still quite bullish longer term tho. I especially like the manganese market. The original SA article is at:
http://seekingalpha.com/article/3999964-south32-best-stock-mining-sector

I'm also putting on starter positions in Potash (POT) and platinum and uranium metals. The uranium rationale is at
http://seekingalpha.com/article/4027206-uranium-commodity

More later.